What role does inflation play in financial planning?

Inflation plays a critical role in financial planning primarily because it erodes the purchasing power of money over time. As prices rise, the same amount of money will buy fewer goods and services in the future compared to today. This means that when planning for long-term financial goals, individuals must account for inflation to ensure that their savings and investments will maintain their value in real terms.

For example, if you have a savings target of $100,000 in 20 years, you need to consider how much that amount will actually be worth at that time due to inflation. If the average inflation rate is 3% per year, the purchasing power of $100,000 will be significantly less two decades from now. Therefore, financial plans that do not take inflation into consideration may fall short of meeting future needs, as they would not reflect the true costs of living and expenses.

Recognizing inflation's impact allows individuals to make informed decisions about saving, investing, and spending. It encourages the use of investment strategies that can potentially outpace inflation, such as stocks or real estate, rather than relying solely on cash or fixed-income investments that may not keep pace with rising prices.